Luis Alvarez/ Getty Images; Illustration by Austin Courregé/Bankrate
Interest is the price you pay to borrow money or the return earned on an investment. For borrowers, interest is most often reflected as an annual percentage of the amount of a loan. This percentage is known as the interest rate on the loan. For investors or savers, interest comes in the form of an annual percentage yield (APY).
For example, a bank will pay you interest when you deposit your money in a high-yield savings account. The bank pays you to hold and use your money to invest in other transactions. Conversely, if you borrow money to pay for a large expense, the lender will charge you interest on top of the amount you borrowed.
How interest works when borrowing
Whenever you borrow money, you are required to pay that base amount (the principal) back to your lender. In addition, you will be required to pay your lender the interest, which is typically an annual percentage of the principal, set for the loan. These loans come in many forms. You may encounter them in the form of credit cards, car loans, mortgages, personal loans and more. Understanding how the interest terms and repayment requirements work is important.
For example, let’s say you borrow $10,000 from your bank in a straightforward loan with a 10 percent interest rate per annum (meaning per year), and the loan is payable in five years. Interest on a typical bank loan is added to monthly payments and is usually compounded monthly. In this example, you’d pay about $2,748.23 in interest over the life of the loan.
You can use Bankrate’s loan calculator to estimate how much interest you would pay on a loan.
How lenders determine interest rates
Typically, banks use a number of different factors to determine your interest rate, including your credit score and debt-to-income ratio, which signal the risk of lending to you. It also depends on the type of lending, such as a credit card or a home loan. On top of this, commercial lenders usually also charge a separate fee for establishing a loan with a customer.
Let’s say you want to apply for a $5,000 loan from your bank. To establish the interest rate it will charge you, your bank must consider what it pays in interest to get the funds it will lend to you (say, 4 percent). The bank will also have loan servicing costs and overhead it will allocate to your interest rate (say, 2 percent). And of course the bank wants to account for default risk and make some profit (say, another 2 percent). To account for these costs, your loan may carry an interest rate around 8 percent.
The difference between interest and compound interest
There are two basic methods to calculate interest: Simple interest and compound interest.
- Simple interest
- With simple interest, your interest rate payments added into your monthly payments, but the interest doesn't compound. For example, a five-year loan of $1,000 with simple interest of 5 percent per year would require $1,250 over the life of the loan ($1,000 principal and $250 in interest). You'd calculate the interest by multiplying the principal, the annual percentage rate (APR) and the length of the loan: $1,000 x 0.05 x 5.
- Compound interest
- This is determined by continually calculating the interest on the principal plus the interest charged for the previous payment period. Compound interest is designed to generate higher returns, at times much higher than simple interest, by compounding the interest earned in the previous terms. If you take out the same loan above but it charges compound interest, you'd pay slightly over $1,332 over the life of the loan ($1,000 principal and $132 in interest).
For large loans with high interest extended over a long term, the increase in total amount paid when interest is compounded can be significant. For this reason, it’s always important to ask your lender or your bank whether a loan or your savings account will have simple or compound interest.
Interest vs. APY
If you’re an investor or saver, understanding APYs — the compounded interest that a financial institution pays you on savings and investments — can help you grow your wealth over time. When you open a savings vehicle, like a savings account or certificate of deposit, the listed APY tells you how much you will earn over a year.
For example, suppose you have a savings account with an APY of 5 percent. That APY accounts for the simple interest rate and the additional interest due to monthly compounding earned in a year. If you had $10,000 in the account, you’d earn $500 in interest after one year.
Bottom line
Interest is a fundamental concept to personal finance. It has a considerable impact on our personal finance decisions, including saving, investing and borrowing. Understanding how interest works, as well as the distinction between simple and compound interest, can help you make informed decisions about how you borrow and save.
— Bankrate’s René Bennett contributed to an update of this story.
FAQs
Interest is the price you pay to borrow money or the return earned on an investment. For borrowers, interest is most often reflected as an annual percentage of the amount of a loan. This percentage is known as the interest rate on the loan.
What is interest and example? ›
Interest, in the financial sense of the word, can be defined as the cost of borrowing money. If you take out a loan from the bank, for example, they will charge you interest on that loan. The amount of interest charged depends on many different factors like credit score, type of loan, etc.
How does interest work explain? ›
When you borrow money, interest is the cost of doing so and is typically expressed as an annual percentage of the loan (or amount of credit card borrowing). When you save money it is the rate your bank or building society will pay you to borrow your money. The money you earn on your savings is also called interest.
What is an example of how interest rates work? ›
If you take out a $300,000 loan from the bank and the loan agreement stipulates that the interest rate on the loan is 4% simple interest, this means that you will have to pay the bank the original loan amount of $300,000 + (4% x $300,000) = $300,000 + $12,000 = $312,000.
What is the best definition of interest '? ›
noun. the feeling of a person whose attention, concern, or curiosity is particularly engaged by something: She has a great interest in the poetry of Donne. something that concerns, involves, draws the attention of, or arouses the curiosity of a person: His interests are philosophy and chess.
What is simple interest easy examples? ›
How to Find Simple Interest?
| Simple Interest | Amount |
|---|
| 1 Year | S.I = (1000 × 5 × 1)/100 = 50 | A = 1000 + 50 = 1050 |
| 2 Year | S.I = (1000 × 5 × 2)/100 = 100 | A = 1000 + 100 = 1100 |
| 3 Year | S.I = (1000 × 5 × 3)/100 = 150 | A = 1000 + 150 = 1150 |
| 10 Year | S.I = (1000 × 5 × 10)/100 = 500 | A = 1000 + 500 = 1500 |
For example, if you take out a $100,000 interest-only ARM at five percent, with an interest only period of 10 years, you'd have to pay about $417 per month (only towards the interest) for the first 10 years.
What is interest explained to kids? ›
It might help to get your kids to think of interest as a reward for saving money or the cost of borrowing it. Interest gets paid at a certain rate, called an annual percentage rate (APR for short). Let's say you pay $100 into a savings account with an APR of 5%. Five percent of $100 is $5.
How do you explain simple interest to a child? ›
When the fee charged for borrowing money is a fixed yearly percentage of the amount borrowed, it is called simple interest. The amount borrowed is called the principal, or the present value of the transaction. The amount owed at the end of the lending period is known as the future value of the principal.
What is interest in real life? ›
Similarly, when the individual borrows the money from the bank, the bank charges some percentage of interest as an additional amount on the principal amount. This amount is also called interest.
The simple interest formula is given by I = PRt where I = interest, P = principal, R = rate, and t = time. Here, I = 10,000 * 0.09 * 5 = $4,500. The total repayment amount is the interest plus the principal, so $4,500 + $10,000 = $14,500 total repayment.
How do you earn interest examples? ›
Simple interest = Principal x Interest rate x Time period
Say you have $1,000 in a savings account with a simple interest rate of 2.00% APY. Using the formula, here's how much you'd earn: 1,000 x 0.02 x 1 = 20.
What does interested mean in a sentence? ›
1. a : wanting to learn more about something or to become involved in something. The listeners were all greatly/very interested in the lecture. students who are interested in archaeology. I'd be interested to learn more about his background.
What words describe interest? ›
Interest Verb/Adjective Words
| Alerted | Appreciated | Avid |
|---|
| Incited | Induced | Inspired |
| Interested | Intrigued | Keen |
| Lucky | Motivated | Prompted |
| Rejoiced | Spurred | Tantalized |
6 more rowsInterest is defined as the cost of borrowing money, as in the case of interest charged on a loan balance. Conversely, interest can also be the rate paid for money on deposit, as in the case of a certificate of deposit. Interest can be calculated in two ways: simple interest or compound interest.
What is a real life example of interest? ›
Some daily life examples of simple interest are automobile loans, loans on instalments, etc. Answer: Car loans are paid every month. The individual who issued the car loan has to pay the EMI every month. The simple interest on the car loans is not constant throughout.
What is an example of interest on interest? ›
Example of Interest on Interest
For example, assume you want to calculate the compound interest on a $1 million deposit. The principal is compounded annually at a rate of 5%. The total number of compounding periods is five, representing five one-year periods.
What is an example of a common interest? ›
Common interest is an interest in the common good that goes beyond narrow self-interest and shared interest in the direction of altruism. Common interests may be more general than self-interest or shared interest. For example, a healthy environment or a strong economy may be a common interest.
What are a person's interests? ›
the feeling of a person whose attention, concern, or curiosity is particularly engaged by something: She has a great interest in the poetry of Donne. something that concerns, involves, draws the attention of, or arouses the curiosity of a person: His interests are philosophy and chess.
